2022 hasn't been a vintage year so farfor industrial giant General Electric (GE -0.28%). The stock is down 21% year to date, and there's real pressure on its full-year earnings outlook. In addition, all four of its businesses are being hurt by rising costs and supply chain pressures. And this is all coming in a year when the company is preparing to begin its breakup plan by spinning off GE Healthcare in early 2023.
So with all of this going on, is the stock worth avoiding, or is it worth buying on a dip based on valuation? Here's the lowdown.
General Electric's headwinds
The stock's headwinds are twofold. First, there's the danger to its earnings outlook. Second, there's the risk that GE won't hit its medium-term targets, which could derail the stock in the future.
I want to focus on the second point. Consider that GE plans to spin off GE Healthcare in early 2023 (while retaining a 19.9% stake) and then combine GE Power and GE Renewable Energy and spin them off into a combined company in early 2024. The remaining company will ostensibly be GE Aviation.
With all three companies expected to hold investment-grade debt, investors have a reason for concern over the risk to the plan. For example, GE Healthcare was heavily hit by supply chain disruptions in the first quarter. Chief financial officer Carolina Dybeck Happe told investors that GE Healthcare's organic revenue growth of 2% in the quarter would have been closer to 9% as "COVID has delayed site readiness and some equipment installations, mainly due to customers' labor and construction material shortages."
If GE Healthcare misses its earnings expectations, then the spinoff might not get the price that management hopes, and the 19.9% stake retained by GE will not be worth as much as many expect. That could turn into a problem if GE needs to sell down the stake to raise cash and ensure the power and renewable energy businesses can be spun off with an acceptable level of debt.
GE Renewable Energy and GE Power
It gets worse. On the earnings call, Dybeck Happe lowered the market's expectations for the renewable energy business, saying, "... due to lower volumes in Onshore Wind North America and the additional inflation we've seen, we expect renewables to be below the outlook range." Given that the previous outlook range calls for GE Renewable Energy to lose $500 million to $700 million in 2022 and only be "approaching breakeven" in 2023, it suggests the segment could be loss-making in 2023. GE Power is doing relatively well, but its guidance only calls for $1 billion to $2 billion in profit in 2023.
As such, the new power/renewable energy company is unlikely to carry a lot of debt when it's spun off in 2024. The reason is that investment-grade debt is usually calculated as a multiple of earnings, and the power/renewable energy business won't have much in the way of earnings in 2023. The end result could be the remaining GE (largely aviation) being saddled with a large amount of debt.
Of course, the uncertainty over this issue is exacerbated by management's lowering of earnings expectations when CEO Larry Culp told investors GE was "trending toward the low end" of its 2022 guidance range.
Is GE undervalued?
On a brighter note, the sell-off in the stock means GE now trades at a market cap of just $82.5 billion. Even if it only hits the low end of the free-cash-flow (FCF) 2022 guidance range of $5.5 billion to $6.5 billion, the stock will trade at just 15 times FCF in 2022. Anything close to the previously forecast $7 billion in FCF in 2023 would see GE at less than 12 times FCF -- there appears to be a large margin of safety there.
Perhaps the best way to look at it is to argue that GE is undervalued, but if you buy in, you better be prepared for some potential downside risk along the way. Markets don't like hearing bad news in the near term, and there's a real risk of that with GE.